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A new approach to deposit insurance

Recent developments
in the Eurozone, specifically Cyprus where the first EU-dictated bail-in of
bank depositors took place, brought to light an important issue which had been
hiding in the shadows: the flawed nature of current deposit insurance schemes.

Some advocate
abolition of deposit insurance because it distorts incentives for banks and
savers. But others believe that it is necessary to avert panic every time a
bank nears its inevitable death. Yet although the two ends of the spectrum
appear to disagree on the specifics of their proposals they both agree that the
deposit insurance scheme needs to change if we want the future of both the
financial sector and the wider economy be brighter than the present. In this
article we present and develop a scheme which will address the need of
depositors for safety without creating distorted incentives, while
simultaneously helping to ensure the viability and stability of the banking
sector in time of crisis.

A flawed scheme

The main
purpose of the deposit insurance scheme is to safeguard depositors in the event
of a financial institution’s bankruptcy. In addition, by guaranteeing the funds
in a person’s account it prevents panic from spreading in the economy, with
horrified citizens rushing to their banks so that they can withdraw their
hard-earned money. Nevertheless,
it has disadvantages. When banks do not have to fear for their customers’ funds
they may indulge in risky speculative deals which destabilize both the bank
itself and the economy in general. This is not pure speculation: in one of the first deposit insurance schemes, bank
failures actually increased due to increased liquidity and terrible choice of
investments (notably real estate).

While the
success of the deposit insurance scheme mainly depends on the good reputation
and financial strength of the state backing it, bank failures can be costly to
the economy. The cost to the state of large bank insolvency can bebillions of currency. This amount has to be generated
either by increasing taxation or by additional Government borrowing, which in
turn will require increased taxation or reduced government spending which,
depending on the state of the economy, may result in a severe recession. Governments
that have currency-issuing capability may alternatively opt for printing money,
which means that the taxpayer will essentially be paying for the bank’s failure
through reduction of real buying power. In the financial crisis of 2008,
taxpayers paid for the mistakes of bankers. The direction of discussion ever
since has been around how to limit the consequences of bank failure for
taxpayers by forcing bank creditors to bear more of the cost. The bail-in
of Cyprus depositors and the haircut suffered by
depositors in the UK’s Southsea
Bank failure were such attempts, but
the price that may be paid for this is greater likelihood of damaging large
deposit bank runs and/or disintermediation of the banking system, introducing
even more funding fragility for banks and increasing their reliance on the
central bank.

Yet abolishing
deposit insurance could have terrible consequences. In the event of a major bank
failure, with thousands of people losing their money, a mass bank run with
disastrous effects on liquidity and asset prices would be likely. In the
absence of deposit insurance a single bank failure may escalate into a systemic
crisis, followed by a major recession with money becoming a scarce resource.
This has already happened before, in 1930, when, in the US,744 banks failed in the
first 10 months of the year, with more than 9,000 failures in the subsequent
decade. Even though we have progressed in many respects since the 1930’s,
convincing someone that his or her money is safe in the bank when a friend of
theirs has lost everything in a bank failure would be difficult. Anyway, the
depositor may be right: the repercussions of one bank’s failure may cause
another togo bankrupt even if no withdrawal of
funds is made.

Although the
deposit insurance scheme bears the name “insurance”, it does not resemble normal
insurance policies. When someone wants to insure a house or an automobile an
amount of money – the premium - has to be paid in advance in order for the
insurance company to assume the risk of compensating the owner if something
goes wrong. This, however, is not the case with deposit insurance: the
depositor does not have to pay any amount of money as a premium for having the
deposited funds insured by the state. Instead, in European countries, the state
imposes a levy on banks to cover the cost of anticipated deposit insurance
claims. Bank depositors unwittingly pay for this through lower interest rates
on their savings: but the burden is also shared by borrowers through higher
interest rates, employees through lower wages and shareholders through smaller
dividends. And in a systemic crisis, the insurance fund is never enough anyway.
The UK’s FSCS wastopped-up
by state funding in
2008 and has had to repay that through additional levies on the financial
institutions that did not fail – hardly an encouragement of sound financial
management.

Nor is the
state necessarily obliged to honour deposit insurance. Iceland refused to
honour deposit insurance for foreign depositors in its banks. The UK and the
Netherlands challenged this in the EFTA court and lost
their case. At present, no European sovereign is
obliged to honour deposit insurance in a systemic banking failure. Fortunately
for the stability of the European banking system, this is not widely known: but
the first
Cyprus bail-in proposal, which would have
partially bailed-in small depositors who were supposedly protected by deposit
insurance, depended on it.

A new proposal

Our proposal
is that depositors should explicitly pay
a premium for the benefit of having the money insured. We limit this to
interest-bearing accounts, because we consider non-interest-bearing
(transaction) accounts to be a social good which should be protected by
government without further cost to citizens. We propose therefore that
transaction accounts would continue to be insured without explicit charge, but
would no longer bear interest: insurance for transaction accounts would continue to be paid by bank levy.

Some might
believe that insurance for interest-bearing accounts could be entirely provided
by the private sector. But recent events suggest otherwise: when AIG became the
largest underwriter for sub-prime mortgage CDS’s, nobody thought it would face
trouble; the company was (and still is) one of the biggest insurers in the
world. Yet, when the whole charade collapsed in 2008, AIG would have gone down with it if the US government had not bailed it out. Even insurance agencies which focus
on extreme catastrophes like hurricanes, earthquakes, etc. would have trouble
repaying the billions needed when it came to a systemic bank failure. In
addition, private insurers would have an incentive to keep that money employed
in projects so it could receive a high rate of return to make up for the costs
of running the business: this runs the risk that in the event of a major bank
failure the funds would be tied up in other investments with no immediate means
of realising them, which would bring the insurer down with the bank and force
the state either to repay the insured depositors itself or let them take the
fall. Neither of these options is a good one,
and we would thus prefer the state to assume the role of the insurer
itself.

When we talk
about the state, we usually mean government. But in this case we think the role
of the insurer should fall to the Central Bank. There are two reasons for this:

The
Central bank is (theoretically) independent of political agendas and has more
access to classified banking data than any other agency. This would allow the
Central Bank to perform a better analysis of the probability of an institution
failing, thus making the insurance premiums commensurate with the realities of
the banking industry.

The
ability of the Central Bank to create unlimited liquidity would enable
depositors to access their money in a systemic crisis without causing fire sales
of assets and price crashes setting off a rapid deflationary spiral as happened
in 2008.

Since in many
countries the Central Bank is also responsible for prudential regulation of the
banking industry, care would be needed to ensure clear separation of function
to avoid conflict of interest. This would be best achieved by maintaining the
insurance fund as a separate legal entity with its own management under the
Central Bank umbrella.

Transparency
would also be important. The fund’s management should be obliged to make public
every quarter the size of the fund, the amount of deposits it insures and
provide an annual report signifying the events of the past year. In addition, the
fund’s financial statements should be audited by independent auditors.

As this fund
would be literally a pool of money, the following questions arise:

How
should this money be invested so that it remains safe and is available when
required?

What
should happen if the accumulated amount of insurance premium became disproportionately large in relation to the value of deposits to be covered?

Regarding the first question, it would
be extremely unwise for deposit insurance funds to be placed with the banks
whose deposits it was intended to insure, or with other institutions that
depend on those banks. Therefore it would probably be sensible for the fund to
be restricted to investments in safe assets such as high-quality government
debt. Central banks already have lists of acceptable collateral for funding and
these would be a good start point for acceptable investments for the insurance
fund, although the insurance fund’s list might need to be more restricted. In
any event, there should be an explicit commitment from the Central Bank to top
up the insurance fund should it suffer losses due to asset failure, including
the failure of its own government’s debt. For Eurozone countries whose central
banks are unable to create money, it might be wise to use the ESM to top up
deposit insurance funds, with the ECB standing as insurer-of-last-resort in the
event of the ESM being unable to cover the losses. Ensuring the safety of
insured depositors and the stability of the banking system is more important
than political arguments over whether or not this would constitute monetization
of state debt.

Regarding the
second question, it is of course necessary for an insurance fund to have a
safety margin in excess of expected claims. This would be invested in safe
assets in the same way as the rest of the fund. However, if the excess became
too great it could be returned to depositors either as a reduction in future
premium payments or as a tax credit. The premium is, after all, effectively an hypothecated tax on savings.

We are now reaching
the most important part of the analysis: who should receive deposit insurance,
how much that insurance should cost and what the insurance limits should be.
The key points are:

Transaction
accounts would be fully insured for no charge, but would no longer bear
interest.

All
interest-bearing deposit accounts would be subject to an insurance premium
which would take the form of a marginal reduction in the interest rate.

On
interest-bearing accounts, customers will have the option of refusing deposit
insurance, in which case they will receive a higher rate of interest but will
not be protected in the event of bank failure.

There
would be no insurance limit on interest-bearing accounts. However, we would recommend
a tiered insurance premium structure: deposit insurance premiums should be
higher for larger amounts and higher interest rates, to reflect the increased
risk they represent and discourage routine placing of large sums in insured
deposit accounts as an alternative to other safe assets.

There
would also be no insurance limit on non-interest-bearing transaction accounts.
However, there would be a time limit on the account, beyond which funds in
excess of a certain amount (possibly the current deposit insurance limit) would
be automatically swept into an interest-bearing account.

To ensure
transparency and avoid mis-selling, account opening procedures will need to be
amended. On account opening, the bank should offer the depositor three options:

A
non-insured account with an interest rate of X

An
insured account with an interest rate of say (1-0.075)*X

An
account without an interest rate (transaction account)

The costs,
benefits and risks of all three should be clearly explained. Additionally, it
should not be possible to open a non-interest-bearing transaction account
without also opening an interest-bearing account, either insured or uninsured.

Under the
present deposit insurance scheme, the amounts insured are limited. There may be
a view that insurance limits should continue under this scheme too. But we
think the risk of destabilising runs on large deposits is sufficiently great
for this not to be a wise decision. The imposition of capital
controls in Cyprus to prevent large deposit runs
has been economically damaging and we think it would be better to remove the
incentive for large deposits to run. We suggest therefore that there should be
no limit to the funds that can be insured in interest-bearing deposit accounts,
but that higher insurance premiums should be charged for larger deposits to
encourage investors to place funds elsewhere. Unlimited insurance on
interest-bearing deposit accounts (for a price) would still give large
investors an alternative to government debt as a safe asset, which in a market
panic could help to ensure the stability of the banking system.

In the case
of accounts with no interest rates (principally transaction accounts) we also
propose that the amount insured should be unlimited. This is because the
current EUR100,000 limit in the European deposit
guarantee scheme is far too low for many corporate and
some individual depositors. Corporate payrolls, for example, can be far in
excess of the EUR100,000 limit and are in no sense “savings” – they are
people’s wages. People buying and selling houses may also have funds far in
excess of the limit going through transaction accounts, and would face
homelessness if these funds were lost due to a bank failure while they were in
transit. The US’s FDIC limit is $250,000, but even this is insufficient for
some depositors. Loss of funds “in transit” can have terrible social and
economic consequences, and we think therefore that deposit insurance should
cover them regardless of the amount. We therefore propose, instead of an
insurance limit, a time limit for funds in excess of the current deposit
insurance limits. Funds in excess of this amount may remain in an insured
non-interest-bearing account for e.g. 60 days, after which they would
automatically be “swept” into an interest-bearing demand deposit account and
insurance would be charged unless the depositor has opted out of insurance on
that account.

Concern has
been expressed that unlimited insurance would lead to abuse of transaction
accounts by large investors seeking safety. However, we think this concern is
unfounded. Under normal circumstances, a large investor would prefer
interest-bearing safe assets over a non-interest-bearing insured account. Only
under exceptional circumstances – say a debt crisis where safe assets were no
longer “safe” – would an investor forego interest for safety. And under these
exceptional circumstances, it would be sensible to allow them to do this in
order to head off destabilising runs and ensure the stability of the financial
system.

In
conclusion....We would like to remind the reader that the current state of the deposit
insurance scheme is far from ideal. We have proposed an alternative which we believe would protect depositors
from losses and prevent destabilizing bank runs without causing moral hazard
for banks and the prospect of unsupportable losses for the state.

I like it. The problem is, though, that the upper bound on premiums would be bounded by the short-term interest rate. Anything greater would lead depositors to take transaction accounts, or simply leave deposits uninsured.

There are around GBP 1.3tn in deposits in Britain. Assuming that all of these deposits found their way into insured savings accounts, if the Bank were to levy around a third of the interest paid, the insurance fund would receive only around 6.5bn - not too dissimilar to the FSCS's 2012 levy of c. 4bn. With interest rates so low, taxpayer intervention can't be ruled out.

That said, premiums earned would benefit from the economic cycle - earning more in good times to protect against lower premiums earned in downturns.

The "deposit insurance" justly is paid by the bank, because the bank as a deposit taking institution enjoys exorbitant privilege of use of the funds for its own account. The risk of loss is not created by the depositor, who has no choice but a commercial bank account if he wants to part take in modern society. The arrangement is a public private partnership between the government/central bank and the commercial banking system operating under its laws, providing us mere mortals, who cannot get an account with the central bank with legal tender.

No deposit taker of non monetary nature can appropriate the depositors goods/wealth in the same way without being sued for embezzlement. It's a legal loophole which is caused by fractional reserve banking. I'm only using this technical term carefully, because bringing it even up can cause reflexive defensive stance by financial professionals.

Deposit guarantee and central banks as lender of last resort are the necessary corollary of fractional reserve banking. Doing away with either while staying fractional is asking for financial mayhem and social unravelling.

I refer you to the considerable evidence for the incidence of taxation falling not on corporations but on their customers, workers and shareholders. Deposit insurance is a form of taxation. Banks don't pay it. Depositors, borrowers, employees and shareholders do.

Correct. The tax is "paid through the corporations" but "economically paid by the depositors, borrowers, employees and shareholders." I firmly believe the idea to have it borne by the depositors is the wrong way to go. They do not enjoy the benefit, as much as it is called "deposit insurance." The benefit of the root cause of the problem, fractional reserve banking, goes to the bank and its shareholders. They should pay for it out of excess profits, generated from a cheap funding base of forcibly appropriated funds.Funds, which incidentally currently do not have a choice to migrate to a fully reserved state unless you close your account and move to cash. Deposit insurance is an insurance paid by the fractionally reserved institution for an exorbitant economic privilege of using other economic agents liquidity as a backstop for their own. These, incidentally being essentially the whole economy unless they are self banked.

If we move to a regime where the depositors pay for this explicitly, we risk the unintentional consequence of the vast majority to wake up to the way money is generated (from thin air on a bank balance sheet) and them having to pay for their own disownment.

There are many ways to make banks safer and regulate their capital, but anything that touches on deposits short of full reserve conversion is explosive. Loss aversion is very deeply ingrained and even a mild tax on a zero yielding account can end in the unforseen.

I'm sorry, I fundamentally disagree with you. Depositors absolutely DO benefit from deposit insurance. If there were no deposit insurance, they would lose their money when banks fail. Deposits are loans to banks and depositors have no automatic right of return.

I do not support your implied call for a change to full reserve banking. I am in agreement with Minsky, who rejected full reserve banking on the grounds that the primary purpose of banks is to provide capital to the economy. Full reserve banking would seriously reduce the capital available to the economy and is therefore in my view a very bad idea.

I don't think that people "waking up" to how our financial system actually works is a bad thing. People should understand that deposits in banks are "at risk", and decide whether they wish to pay to mitigate that risk. At present they are kept in the dark and they pay whether they wish to or not. Your notion that the bank levy can be paid purely from profits without affecting deposit rates is simply unrealistic.

You've obviously failed to notice that we are not proposing a charge for deposit insurance on non-interest bearing accounts. It is up to depositors to exert sufficient pressure on banks to ensure that the rates offered on insured interest-bearing accounts give yields above zero.

It seems to me they are essentially lending base money to the bank (even if the depositor doesn't actually deposit any physical cash in the first place). At the end of the day the bank owes base money to the depositor in some form. Would you agree with that, or not?

No. They are lending credit money to the bank: the deposit was ultimately created from someone else's borrowing. What is owed is what we call M1, not base money (M0). However, the M1 debt can be settled in physical currency, which is part of base money.

A bank creates a new deposit out of "thin air" when it lends. That deposit is then spent by the borrower, ending as the recipient's demand deposit in either the same bank or a different one. It is then spent on by the recipient and ends up as a different demand deposit in a bank somewhere, and is spent on by the next recipient - and so on. A bank deposit is therefore - ultimately - created through borrowing. That applies whether it is created as part of lending, physically deposited as cash or received by electronic transfer.

Right, but a bank deposit is a debt owed by a bank. A bank can create a deposit out of thin air because all it's doing is going into debt to a depositor.

When a bank makes a loan, it creates a new deposit. The loan is a debt owed by the borrower to the bank, and the deposit is a debt owed by the bank to the borrower/depositor.

If the borrower spends the deposit and it ends up with another depositor at the same bank, the deposit then represents a debt owed by the bank to that other depositor.

So what does the bank actually owe to the depositor? You said it owes M1 money, i.e. a bank deposit. But a bank deposit is a bank debt. How can the bank only owe more of its own debt?

For example, if you lend me some money, I can't repay my debt by simply giving you another one of my IOUs, can I? I can't repay my debt by promising to repay my debt. I wouldn't have repaid my debt, because I would still be in debt to you!

I'm trying to get my head around this idea, so I appreciate the explanation..

Strictly speaking, all bank deposits are redeemable in physical cash - if you want to regard this as "banks owe base money" you can. But it isn't a meaningful concept in the Western world. We actually run on bank credit, not on physical currency. That's how our financial system works. When you pay a bill from your deposit account, your bank's debt to you decreases just as much as if you had withdrawn cash from your account, but no physical currency is involved. And the recipient's bank now owes the recipient more, but the recipient hasn't deposited any physical cash. Bank debts CAN be settled in physical currency, but they don't have to be. We use the debt ITSELF as money.

But it is very important that a creditor of ABC Bank can require a claim against ABC Bank to be settled by delivery of currency or a claim against a different bank. If ABC Bank could always discharge its debts by delivery of more of its own debt, then you would have the problem Phil is concerned with. It is also important (at least within the way most modern monetary economies operate) that creditors of at least some private sector banks can require settlement by delivery of currency or central bank reserves, even if in practice they do not do so.

As far as I'm concerned a bank deposit is a promise to pay not only physical currency but also electronic currency.

I can't directly get my hands on central bank reserve balances, but if I have a bank deposit I can instruct my bank to pay central bank reserves to someone else on my behalf, like the Treasury for example. So in that sense I have a claim to ownership of them.

I agree that bank debts are money. But those debts are currently guaranteed by the state and the taxpayer, and supported by the state's central bank. So it isn't really right to think of them as private debts.

"depositors should explicitly pay a premium for the benefit of having the money insured. We limit this to interest-bearing accounts" Seems like there is less and less reason for people to put their money in the bank, especially given that you agree that a bank deposit is a loan from the depositor to the bank,for which the depositor is receiving less and less benefit while the banks continue to make money from depositors' funds and foist more and more the cost of doing so upon those same depositors.

To address the issue of banks taking undue risks, the premium on the deposit insurance should be tied to some measure of the riskiness of the bank. Just as smokers pay higher rates for life insurance, depositors in banks with low capital ratios or high concentration in one type of lending (real estate) should pay a higher premium than with a stronger bank.

I agree with this. Have to say that my colleague Euronomist doesn't, though - he is concerned that higher premium could encourage depositors to remove their money, resulting in bank runs. I think the chances of destabilising bank runs due to premium divergence are vanishingly small, but I agree that there might be "slow runs" that would eventually drive higher-risk banks out of business. Personally I think this is a good thing. I am hoping to persuade Euronomist round to my point of view!

In another comment,Ms.Coppola says,"Once you have lent the money to the bank it is not "your property" that you have entrusted to them for safe keeping." Interesting that does not apply the other way around when the banks lend "their property" to me. When they lend to me, I, the borrower, pays for the risk the bank takes in lending to me via the interest rate. But is the bank borrows my deposit, the proposal is that I, now the lender must pay for the risk. Banks and their cheerleaders seem to be in favor of "heads I win, tails you lose" policies.

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